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Project Finance Emu

Project Finance Emu

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Published by: DR. BHAVIN PATEL on Aug 17, 2010
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09/05/2010

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Risk Management in Context of Project Financing of Infrastructure Project

Prof. GLENN P. JENKINS
DEPARTMENT OF ECONOMICS EASTERN MEDITERRANEAN UNIVERSITY NORTH CYPRUS

1

PROJECT FINANCE What is Project Finance? ‡ No universally accepted definition of the term ³Project Financing´ -.different people use it in different senses. 2 . ‡ Project financing refers to a financing in which lenders to a project look primarily to the cash flow and assets of that project as the source of payment of their loans.

‡ Scope further expanded to include all kinds of infrastructure projects. mining. transportation. utilities and large industrial projects. ‡ Today even medium-scale projects (US $5 million) can use project finance 3 . ‡ Later extended to infrastructure.Origins and Development of Project Finance ‡ Project financing had its origins in the energy industry in industrialized countries (oil & gas production loans).

Development of Project Finance 1994 ‡ Number of Project Finance Transactions in emerging markets 50 1996 400 1997 380 ‡ 41% of emerging markets project finance flows between 1994 and 1998 went to Asia. ‡ About 75% of project finance flows worldwide went to infrastructure and energy in 1999. Source (IFC 1999). Capital Data Project Finance Ware (2000) 4 .

Why Project Financing? ‡ Project Owners¶ Perspective ± Size and cost of projects ± Risk minimization ± Preservation of borrowing capacity and credit rating ± May be only way that enough funds can be raised 5 .

Private Public Partnerships in Infrastructure ‡ Project Finance is mainly used for INFRASTRUCTURE DEVELOPMENT AND CAPITAL INTENSIVE PROJECTS LIKE ENERGY AND POWER PLANTS ‡ Infrastructure traditionally financed and managed by governments ‡ Demand for infrastructure has been growing faster than available government funding particularly in emerging economies. ‡ So. involvement of the Private Sector in essential in financing and operation. 6 .

7 . y can be completed without undue uncertainty.Main Characteristics of Suitable Investments for Projects Financing y The ideal candidates for project financing are capital investment projects that y are capable of functioning as independent economic units. and y When completed. will be worth demonstrably more than they cost to complete.

project-related contracts.Main Characteristics of Project Finance (Summary) ± Project is a distinct legal entity. ± Lenders may have recourse to their funds through other stakeholders through various types of security arrangements. and project cash flows are separated to a large degree from the sponsors. ± Sponsors provide limited or no recourse to cash flow from other assets. 8 . ± Project assets. ± Two-phase financing is common.

The Basic Elements of a Project Financing Lenders Loan funds Debt repayment Purchase contract(s) Purchasers Output Equity funds Returns to investors Cash deficiency agreement and other forms of credit support Raw materials Suppliers Supply contract(s) Assets comprising the project Equity investors 9 .

Prerequisites for Project Financing ‡ Financial Analysis ‡ Economic Analysis ‡ Risk Analysis 10 .

11 .It¶s All About Risk! The key to project financing is the reallocation of any risk away from the lenders to the project.

Debt/Equity.Definition of Project Completion ‡ Principle Categories of Risk: Pre-Completion and PostCompletion ‡ Physical Completion ± Project is physically complete according to technical design criteria. ‡ Mechanical Completion ± Project can sustain production at a specified capacity for a certain period of time. Debt Service Capacity ratios) 12 . ‡ Financial Completion (financial sustainability) ± Project can produce under a certain unit cost for a certain period of time & meets certain financial ratios (current ratio.

Attain Third party credit support for weak sponsor (e.Letter of Credit) .Turn key construction contract 13 ‡Construction/Design defects .g.Management and Alleviation of Risks Principle Categories of Risk: Pre-Completion and Post-Completion A:Pre-Completion Risks: Types of Risks Some Examples of Ways to Reduce or Shift Risk Away from Financial Institution ‡Participant Risks -Sponsor commitment to project ..Experienced Contractor .Reduce Magnitude of investment? -Require Lower Debt/Equity ratio -Finance investment through equity then by debt ± Financially weak sponsor .Cross default to other sponsors .

Tests: Mechanical/Financial for completion .Assumption of Debt by Sponsors if not completed satisfactorily Types of Risks ‡Process failure ‡Completion Risks ± Cost overruns ± Project not completed ± Project does not attain mechanical efficiency 14 .Fixed (real) Price Contract .Completion Guarantee .Management and Alleviation of Risks A:Pre-Completion Risks (cont¶d): Some Examples of Ways to Reduce or Shift Risk Away from Financial Institution .Process / Equipment warranties .Pre-Agreed overrun funding .

Insurance to guarantee minimum cash ‡ Production/Operating Risks ± Operating difficulty leads to insufficient cash flow 15 .B. Post-Completion Risks Types of Risks Some Examples of Ways to Reduce or Shift Risk Away from Financial Institution ‡ Natural Resource/Raw Material ± Availability of raw materials .Proven technology .Ready spot market .Performance warranties on equipments .Firm supply contracts .Experienced Operator/ Management Team .Independent reserve certification .Example: Mining Projects: reserves twice planned mining volume .

Price escalation provisions ‡ Force Majeure Risks ±Strikes. etc.Minimum volume/floor price provisions . . floods. Post-Completion Risks Some Examples of Ways to Reduce or Shift Risk Away from Financial Institution Types of Risks ‡ Market Risk ±Volume -cannot sell entire output .Debt service reserve fund 16 . earthquakes.B.cannot sell output at profit .Long term contract with creditworthy buyers :take-or-pay.Insurance . take-and-pay ±Price . take-if-delivered.

currency inconvertibility.Built-in flexibility in debt service obligations 17 ‡ Abandonment Risk ±Sponsors walk away from project banks to run project ‡ Other Risks: Not really project risks but may include: ±Syndication risk ±Currency risk ±Interest rate exposure ±Rigid debt service ±Hair trigger defaults .Private insurance: AIG.Abandonment test in agreement for closure based on historical and projected costs and revenues . LLOYDS . etc. political risk assurances .Multilateral or Bilateral involvement .Currency swaps / hedges . COFACE. .Interest rate swaps .Types of Risks Some Examples of Ways to Reduce or Shift Risk Away from Financial Institution ‡ Political Risk ±Covers range of issues from nationalization/expropriation. EXIM . changes in tax and other laws.Official insurance: OPIC.Offshore Escrow Accounts .Host govt.Secure strong lead financial institution .Assumption of debt .

y Project financing can only work for those projects that can establish such relationships and maintain them at an acceptable cost. y To arrange a project financing. 18 . there must be a genuine ³community of interest´ among the parties involved in the project.The Need for Contracts y Project financing arrangements invariably involve strong contractual relationships among multiple parties. y Only then will all parties do everything they can to make sure that it does succeed. y In must be in each party¶s best interest for the project financing to succeed.

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